Perceived value

A common analytical method in pricing is Conjoint Analysis. While this has evolved into far more sophisticated methods, at its core Conjoint Analysis is about finding how much utility different customers assign to different “features/aspects” of a product. If you know the utilities you can find how to price different product versions.

Here is a quick tutorial if you want to know more.

In the case of tablets you can think of iPad and Fire to be a collection of features (or benefits) that customers assign perceived utilities. So when you add up the utility assignment for each feature you get the total utility.

Likely true. But the point to note is the utility value from features is neither absolute nor intrinsic. It is perceived utility and it differs from segment to segment. Furthermore there are the “Fudge Factor” – the unknowns, Brand premium and Ecosystem Premium.

Apple likely found a sizeable segment – different from Amazon’s target segment – that assigns lot more value to Apple’s Brand and Ecosystem than they do for Amazon’s Brand and Ecosystem and hence is willing to pay $130 more for iPad mini. (Technically it is $95 more if you consider Fire without “Special Offers” and add price of Fire charger).

Amazon’s comparison is valid. But if the customer segments and their value allocation is not the same, then it does not matter that Fire packs better features at lower price. That is likely why Amazon decided to pull the Ad?

It is fair to say everyone loves a discount. There is data to support the claim from years of Black Friday discounting that not only makes customers skip sleep and stand in cold weather for hours but also generates considerable revenue for the retailers. Then there are the group buying discounts made popular by GroupOn.

At the individual customer level, previous research done on customer preference for discounting point to both rational economic and emotional reasons. Kahneman and Tversky showed, customers prefer discounts even if they saved lower amount in absolute terms.

Thaler in his work on Mental Accounting and Consumer choice provide evidence of emotional (non-financial) reasons for why we may be motivated by discounts.

So we all value deals for rational and irrational reasons. But how much do we value the product after the initial buying decision? More specifically, since we do not know the absolute values, how much relative value do we place on a product bought on a discount vs. an identical and substitutable product bought without the discount?

There are three distinct possibilities.

Hypothesis 1: If we treat our customers as rational (ignoring the contradiction), once they bought the product at whatever price, the costs are sunk. How much relative value consumers get from each product should depend only on its own merits and independent of initial discount. At the very least, the choice between the two should be no different from a random choice.

Hypothesis 2: If we treat our customers consistent with their previous action of seeking discounts for non-financial reasons, we should expect them to value the product bought at a discount higher than that of the one bought at full price. This hypothesis is further reinforced by endowment effect and cognitive dissonance (I must really value this product, otherwise I would not have stood in line for it).

Hypothesis 3: Customers value the full price product more than the one bought at discount (remember the preconditions – identical and substitutable products).

So I conducted an experiment. The data and analysis show that the last scenario, Hypothesis 3, is more likely than the other two.

The experiment was designed to get customers to reveal their preference by asking them to give away one of the two identical products of same price:

One they bought at full price

Other they bought at 50% discount

As it turns out, customers are more likely to keep for themselves the full priced product and happily give away half-priced identical product. So while discounting may bring in customers, it may hurt by depressing the relative value of the product to the customers.

What does this mean to you as a marketer?

Think again before running 50% deals on any group buying site or allowing your product to be bundled and sold at a discount by other channels.

Attracted by large user base from giving away your product for free? Consider loss in perceived value to the customer.

Know the customer’s end use of the product. If they are predominantly buying it for their own use, discounting most likely will not help improve lifetime value of the customer. If they are buying it for others, discounting helps.

I relied on convenient sampling and applied Bayesian hypothesis testing. Compared to conventional, run of the mill hypothesis testing, say testing for statistical significance at 95% confidence level using Chi-square test for this case, Bayesian Hypothesis testing allows to test multiple hypothesis at the same time and help state the results in terms of probabilities instead of as absolute truths.

Results are subject to sampling errors, and do not take into account segmentation differences. This is also stated preference study and not a revealed preference study.

If we always made rational decisions that is based only on economic reasons the price we pay for products and services we buy should leave us feeling that these are worth more than it cost them. At the very least these two should match. The difference we perceive, between what the product is really worth to us and the price we paid is called the consumer surplus. But the problem with this is we are not all economists or rational number crunchers. I am going to exclude emotional decision making for this post and focus simply on our quantitative ability or the lack of it.

I do not mean our capabilities with numbers but our ability to assign a dollar figure to the value we derive from products and services. Imagine you have an hand held device that can read bar code and an LCD display. You read the bar codes of any product and it displays the value you will get. Then you look at the price and decide whether this leaves you a positive consumer surplus or not and decide whether or not to buy it. The value we get is our Willingness to Pay. We should be willing to pay any price up that and not more than that.

Unfortunately we do not have a device and even if there is one the device must not only work differently for each person since the value you get is different from mine and from everyone else but also work differently for the same person based on time and context.

There is no such device. So how do we know whether are not a product is worth the price we paid for it? We never will for sure. I have heard a simpler and better definition for consumer surplus, ” it is the size of the smile on our face after we buy the product”. If we kick ourselves for buying at a price obviously it means we paid too much.

The story does not end there, there are complexities like reference price, how marketing can increase our willingness to pay, how lack of value information (with no magic barcode reader) can artificially suppress our willingness to pay. There are emotional purchases in which we convince ourselves of higher willingness to pay or adjust our willingness to pay post-purchase to assuage our concerns of overpaying.

Now you know why microeconomics alone is not enough to define pricing strategies for marketers and the need for behavioral economics and behavioral pricing. I look forward to writing a few articles in behavioral pricing in the coming weeks.

Here is an Ad for Wendy’s double stack burger that shows very neatly Endowment Effect. (wait for 7 seconds into the video for the Wendy’s Ad, as the beginning of the video has another Ad for Religulous)

The Adman says, “your burger has increased in value”. This is only partly true as the value is in the minds of the customer who is holding it and it is the perceived value. Endowment Effect is a theory introduced by Thaler (of Nudge) and it states that people who own things tend to value these more than others. Since their perceived value goes up, they are less reluctant to part with the goods at prices they bought or at the current market price.

This is the same reason home prices are not falling as fast as economic theories suggest – people own their homes more than the market is willing to pay.

As a corollary, if the customer feels ownership of the object then their willingness to pay goes up as well. An example of this was discussed in my last post You touch it! You own it!